On China, Japan and the Eurozone’s determining US interest rates
There are a lot of stories floating around today that moves by central banks in China, Japan and Europe are having – and will continue to have a noticeable impact on US interest rates. Some are even saying this marks the end of the long bond bull market. I am sceptical of these claims because I have fundamental disagreements with the ‘model’ they use to make those claims.
In my model of things, the Fed exerts a dominant influence across the yield curve, not just on the short end.And what that effectively means is that US domestic interest rates are not dictated by flows into and out of US dollars but by domestic concerns. Ben Bernanke put it well when writing about this:
it helps to decompose the yield on any particular bond, such as a Treasury bond issued by the US government, into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium.
When you do that, what you see is a yield curve dominated by inflation expectations and the outlook for real short-term interest rates plus a ‘time premium’ for the risk of holding an asset with a fixed payout.
One might try to make a case for the term premium being dominated by foreign interests; Bernanke did so ahead of the Great Financial Crisis with his savings glut theory. But I believe this was a mistake, because it helped the Fed miss the signal a flattening yield curve was sending. So I wouldn’t make that case. Inflation and real interest rates are US domestic issues that are not dictated by foreign central bank actions.
In my model of today’s fiat currency, floating-exchange rate system, it is the currency that is the release valve. If foreigners demand fewer dollars, the dollar goes down in value. If they demand more, it goes up. Treasury rates are not affected.
And that brings up the special case of China. Just after the last financial crisis had started to recede, a meme started to pop up where China dictated what happened in the US because of its large holding of US Treasury bonds. The theory was that, if China decided to punish the US, all it needed to do was sell its holdings of US Treasury bonds and interest rates would skyrocket. This is bogus stuff as we wrote at Credit Writedowns at the time.
The reality is that China has a crawling peg exchange rate arrangement with the US. And at any given exchange rate, it must accumulate or reduce net foreign claims consistent with its current account balance. The reason the Chinese have accumulated Treasuries is because they have pegged their currency to the US dollar at a rate which created an imbalance with the United States. The Chinese could simply change the value of their currency vis-a-vis the dollar and rectify this problem. If they did, it would be the currency that changed in value, not the Treasury yield.
One other thing, once China has accumulated US dollar assets, the principal question is which US dollar assets to buy. Those dollars have to ‘held’ in some form, and Treasuries are the most liquid, safest form.
Bottom line: I believe Treasury rates are determined by fundamentals — expected inflation, the predicted path of short-term real rates as dictated by the Fed, and a term premium. Other people are de facto using a supply and demand flow model to represent the same market. Those flows are currency flows, and it is at the currency level where those changes should occur.